Friday, April 8, 2011

Fed Policy Update

The minutes from the March 15 FOMC meeting contain some interesting things. First, there was some discussion about modifications to the QE2 asset purchase program, begun in November 2010 and set for completion at the end of June:

Members emphasized that the Committee would continue to regularly review the pace of its securities purchases and the overall size of the asset purchase program in light of incoming information--including information on the outlook for economic activity, developments in financial markets, and the efficacy of the purchase program and any unintended consequences that might arise--and would adjust the program as needed to best foster maximum employment and price stability. A few members noted that evidence of a stronger recovery, or of higher inflation or rising inflation expectations, could make it appropriate to reduce the pace or overall size of the purchase program. Several others indicated that they did not anticipate making adjustments to the program before its intended completion.

Thus, on March 15, some on the committee could imagine conditions under which they would want to scale back the QE2 program. Indeed, on April 5, Jim Bullard, St. Louis Fed President, said he would push for just that, but his remarks seemed to indicate that he did not expect much support.

Why would any of the FOMC participants want to purchase less long-maturity Treasuries than the $600 billion planned at the inception of QE2? Some of them are worried about inflation. But some are not. See this exchange:

In contrast to headline inflation, core inflation and other measures of underlying inflation remained subdued, though they appeared to have bottomed out. A number of participants noted that, with significant slack in resource utilization and with longer-term inflation expectations stable, underlying inflation likely would remain subdued for some time. However, the importance of resource slack as a factor influencing inflation was debated. Some participants pointed to research indicating that measures of slack were useful in predicting inflation. Others argued that, historically, such measures were only modestly helpful in explaining large movements in inflation; one noted the 2003-04 episode in which core inflation rose rapidly over a few quarters even though there appeared to be substantial resource slack.

The disagreement is over how seriously we should take the Phillips curve. Friedman of course told us long ago that any level of "resource slack," however measured, could be consistent with any inflation rate. That is basically what theory tells us as well, though New Keynesian models and other models with nonneutralities of money can deliver short-run Phillips curve correlations. This older paper by Andy Atkeson and Lee Ohanian says something about this issue. I'm not sure where I heard this (might have been Andy Atkeson himself), but we could summarize the results of the paper as saying that a monkey could do as well at forecasting inflation as an economist armed with a Phillips curve, or maybe a monkey armed with a Phillips curve. This more recent work, by Zheng Liu and Glenn Rudebusch at the San Francisco Fed seems to want to suggest otherwise. Of course, a key issue here is how one is supposed to measure "resource slack." Presumably this should be a measure of the distance between the economically efficient level of aggregate economic activity and actual aggregate economic activity. In spite of Friedman's focus on the "natural rate of unemployment," it seems wrongheaded to focus a lot of attention on the number of people actively searching for work.

Now, in the FOMC minutes, we also have this:

Several of them [FOMC members] indicated, in light of recent developments, that the risks to their forecasts of inflation had shifted somewhat to the upside. Finally, a few participants noted that if the large size of the Federal Reserve's balance sheet were to lead the public to doubt the Committee's ability to withdraw monetary accommodation when appropriate, the result could be upward pressure on inflation expectations and so on actual inflation. To mitigate such risks, participants agreed that the Committee would continue its planning for the eventual exit from the current, exceptionally accommodative stance of monetary policy. In light of uncertainty about the economic outlook, it was seen as prudent to consider possible exit strategies for a range of potential economic outcomes. A few participants indicated that economic conditions might warrant a move toward less-accommodative monetary policy this year; a few others noted that exceptional policy accommodation could be appropriate beyond 2011.

Now, here, some FOMC participants appear to be taking an even stronger position than that resource slack can hold down the inflation rate. In the view of some, it seems that we could go well into next year with a highly accommodative policy (the policy rate at 0.25% for an extended period) and not experience inflation, because a "tight" economy is in fact a necessary condition for high inflation. I certainly disagree with that view, for reasons discussed here.

Another interesting tidbit is this Wall Street Journal piece by Allan Meltzer. He questions the Fed's Phillips-curve logic, which is fine, but then comes this:

One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its "quantitative easing" policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?

What can he mean here? How does the size of the balance sheet threaten to "finance" more inflation? Meltzer certainly does not explain what he has in mind, but he comes up with a "solution" to the "problem:"

One idea is for the Fed to create its own version of a "bad bank." The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity.

Then:

The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature.

How is this a solution to anything? As I discuss here, the key issue is whether the Fed should sell its long-maturity assets sooner rather than later, where "later" could be never. So much for Old Monetarists.

3 comments:

How is a "hefty balance sheet" a source of inflation risk? Metzler should know that the supply of reserves is perfectly elastic at any given FFR. On any given day, the system could force the Fed to supply $2tr of reserves in order to keep the FFR at zero. The pre-existence of ER's is irrelevant. Even if the system experienced widespread currency withdrawals, it could also access the necessary reserves through OMO. So what is the difference between $2tr in ER's and $2tr in OMO? I'm sure I am missing something, because Metzler and a dozens of others who make the "ER's are inflationary" claim must be right.

IMO, ER's are merely an artifact of the attempt to depress term rates. The more they accumulate, the more term rates will rise when they stop. If the Fed doesn't want term rates to rise, it must, all else equal, never stop accumulating. It is expectations of chronic deficit monetization that are inflationary, not ER's per se. There are two reasons why markets would expect the Fed to avoid term rate increases: 1) it would jeopardize a recovery and raise unemployment from already-high levels; and 2) it would risk exploding deficit projections in out-years, sparking an adverse feedback loop of higher term rates/higher deficit projections. In a nutshell, both factors are plausible in the absence of a self-sustaining (non-stimulated) recovery. This is what the risks through QE but never admits.

Banks would probably not finance commercial loans with funds from the fed funds market, but a risk-reward analysis could convince banks to move funds from their reserve accounts at the fed into C&I, consumer, and/or real-estate loans.